Thursday, July 15, 2010

Privatization of Hydropower: Nepal’s Experience

Ratna Sansar Shrestha

Almost nine decades of Nepal’s experience in its attempts at the development of its famed hydropower potential of 83,000 MW (economically feasible potential being 44,000 MW) through the public sector leaves much to be desired in terms of accomplishments (the total generation capacity installed so far is a mere 250 MW). Nepal’s first hydropower plant was constructed at Pharping in Kathmandu Valley over 85 years ago. Besides, so far less than 15% of the total population of Nepal have been granted access to electricity. The restlessness manifest in such a poor show coincided with the winds of economic liberalization, privatization and globalization sweeping through South Asia which did not leave Nepal untouched, adhering to the worldwide trend. Therefore, private sector was roped into this sector not only to alleviate the problem of rampant power shortage in the area that were getting the electricity, but this route was also viewed as an avenue for overall development of Nepali economy, in order to help jumpstart the economy.

Hydropower Development Policy
The first popularly elected government of Nepal, formed subsequent to the restoration of democracy in 1989, formulated Hydropower Development Policy, 1992. The rationale of the new hydropower policy were (a) to make alternative arrangement to meet the interim demand, (b) to meet demand of the hilly and remote Himalayan region deprived of national electricity system, and (c) to extend distribution system in rural areas bereft of electrification. These three reasons were being attempted to be addressed while “huge” projects like Arun (402 MW) and Kaligandaki (100 MW) would have been in the construction time scale of 7-12 years. His Majesty’s Government of Nepal (HMGN) also promulgated Water Resources Act, 1992 and Electricity Act, 1992 after these were passed by the Parliament, within the parameters laid down by the policy. From this it becomes evident that the new policy intended to limit private sector participation in hydropower projects of up to 100 MW and it favored public sector for projects bigger than 100 MW.

Butwal Power Company Ltd.
With the formulation of the new set of policy and promulgation of legislation on hydropower development, Butwal Power Company Ltd. (BPC) became the first Nepali organization in the private sector operating two hydropower plants (5.1 MW and 12 MW). This Company was initially launched by the United Mission to Nepal (UMN – an organization of Christian Missionaries) and it was reposed with the responsibility to construct these power plants funded by Norwegian grant. Under the old economic regimen these grant funded power plants would have been handed over to HMGN by UMN upon completion and then HMGN, in turn, would have again handed them over to Nepal Electricity Authority (NEA, the only utility generating and distributing electricity in Nepal) in exchange of equity therein for the value of the power plants.

By the time these power plants came into operation HMGN had changed its hydropower policy and HMGN, in the interest of the new policy, handed over these power plants to BPC itself, for operation, in exchange of equity therein in 1994. This resulted in HMGN holding 97% of equity in this company. The hand over was consummated with the specific understanding that HMGN will divest itself of its substantial ownership interest in BPC in the near future. At the moment moves are afoot for HMGN to divest 75% of the outstanding shares that it holds in this company. This is the first stage operation at disinvestment by HMGN in BPC. These shares are to be sold in block to one bidder or a consortium of bidders. In the second phase HMGN plans to sell another 12% of the outstanding shares to BPC employees (on favorable terms) and the general public in Nepal. Ultimately, thus, HMGN plans to retain only 10% of the outstanding shares in BPC.

Khimti
Khimti has taken the place of a prominent landmark in the history of hydropower development in the private sector. The advent of new policy for the development of hydropower gave impetus to the inflow of Norwegian investment in Khimti Hydropower Project (run of the river type) on BOOT basis. ABB Kraft AS, Kværner Energy a.s (KEN) and Statkraft SF (SK) from Norway and BPC from Nepal, the promoters/developers of Khimti, succeeded in achieving financial closure on 26th June 1996 (estimated total project cost is US $ 140 million).

All of the abvoe parties, alternately called sponsors, are also involved in this project in the capacity of Contractors. SK’s construction subsidiary, known as Statkraft Anlegg, formed a consortium with Himal Hydro & General Construction Ltd. from Nepal for the engineering and civil works worth US $ 52 million. The other two Norwegian companies (ABB and KEN) have teamed up for a Contract to supply and install/erect electro-mechanical equipment for the project (worth US $ 36 million). Similarly, BPC has teamed with SK’s another subsidiary known as Statkraft Engineering (SE) for the Project Management works for about US $ 5 million. SE has also bagged the sub-contract for the engineering design of the project from the civil consortium. Nepal Hydro Electric Pvt. Ltd. also has a small subcontract from the equipment supply contractor.

Bhote Koshi
Following the commencement of construction of Khimti Project, Bhote Koshi Power Project (run of the river type) also achieved financial closure at the end of 1996. Panda Energy, Harza Engineering (both from USA) and Himal International Power Corporation (from Nepal) are the promoters of this Project, estimated to cost US $ 98 million in total. This Project did not follow Khimti model for the implementation/execution aspect. Gezhouba Construction Group Corporation, China was awarded engineering, procurement and construction (EPC) contract for this project on a “turn key” basis, reportedly, at US $ 48 million.Risk Management
With the involvement of the private sector in the hydropower development – a capital intensive venture, a number of risks that manifests in such investment decision came to the light. Various players in this venture like the investors, lenders, contractors, HMGN, NEA, etc. needed to successfully manage them to the best of their interest. It is quite an interesting study to see how did these risks get managed and who ended up bearing how much of which risks.Devaluation Risk and Repatriation Risk
As Nepali currency (Rupee) happens to be very weak and, importantly, it is not fully convertible, devaluation risk and repatriation risk, respectively, attracted highest level of attention. In the case of both Khimti and Bhote Koshi Projects, NEA has accepted the devaluation risk by having the tariff fixed in US Dollars thereby insulating the investors from the vagaries of foreign exchange rate changes between US Dollars and Nepali Rupee. While HMGN has covered the investors from the repatriation risk as it has made commitment to make available necessary foreign exchange to repatriate the full amount of monthly “demand charge” instantly each month to these projects.

Payment Risk
Further , the lenders and investors perceived payment risk emanating from lack of creditworthiness on the part of NEA. This has come about due to the fact that in many developing countries, state-owned utilities do not have established credit histories and also suffer from records of poor management. HMGN has issued counter guarantee to cover for payment risk by standing surety to the fact that NEA will pay its dues to these projects in time and in the case of NEA’s failure to meet its obligations HMGN is required to promptly make payments to mitigate NEA’s delinquency. The investors have exacted such a guarantee from HMGN, much against the decree of World Bank and IMF, notwithstanding the fact that NEA is also required to substantiate its willingness and ability to meet its payment obligations by opening letters of credit in favor of the projects to cover for monthly demand charge. The question of counter guarantee must be viewed in the backdrop of the fact that NEA is wholly owned by HMGN and even in situations where HMGN has not signed off to a counter guarantee, it is highly unlikely that HMGN will allow NEA to default on its obligations to international investors like IFC, ADB, etc. and other foreign investors backed by them.Inflation Risk
Another risk that the investors wanted to be insulated from was inflation risk, thus ensuring that its revenue stream is not diluted by inflation, wishing to receive same revenue stream in constant US Dollars during the term of the Power Purchase Agreement (PPA). NEA has taken on this risk by agreeing to the escalation of tariff based on consumer price index.

Market Risk and Revenue Risk
On the demand side a serious risk for such a capital intensive project is posed by the question of availability of market for the energy generated. This risk owes its existence to the single-buyer situation; NEA enjoys monopsony status in the energy market of Nepal. The market risk was neutralized by having a long term PPA signed with NEA, twenty years in the case of Khimti and twenty-five years in the case of Bhote Koshi.

The ability of run-of-the-river types of project to generate optimum revenue is subject to its ability to sell all the power generated in all seasons, typically generating more in the wet season and less in dry season. This facet of the problem gains importance in view of the fact that electrical energy cannot be stored or under currently available technology can be stored at prohibitive cost. In Nepal the problem gets aggravated by the fact that the demand for energy reaches its peak in the dry season while the demand in the wet season is rather low. Such revenue risk has been covered for these projects by the “take-or-pay” nature of the PPA NEA has signed, which requires NEA to accept every joule of contract energy produced by these plants irrespective of whether NEA is willing and able to sell or not.Interest Rate Risk
As the financial market including stock market and currency market is fraught with huge and frequent fluctuation, generally financial/banking institutions are reluctant to lend money at fixed rate of interest; floating rate of interest (fixed for shorter periods of time) is generally preferred by the lenders. However, floating interest rate exposes an investor to the interest rate risk and an adverse change in it impacts their return, hence, adversely. Therefore, developers prefer fixed (fixed for the term of the loan) rate of interest for a project with long gestation period and longer repayment period. In the case of both Khimti and Bhote Koshi projects, NEA has covered the developers from the interest rate risk in view of the fact that the sponsors opted for costly fixed interest rate for its loans (high debt/equity ratio) and the US Dollar denominated tariff rate negotiated with the NEA incorporates a mechanism to recover total project cost plus a specific rate of return. In essence the developers are guaranteed the recovery of all of their construction costs (both hard and soft costs that includes all foreseeable cost including the cost of mitigation of socioeconomic and environmental impact, including an additional budgetary provision for physical contingency) along with a specified rate of return through tariff.

Construction Risks
Construction of a hydropower project entails various construction risks like time and cost “overrun” risks, force majeure risk, socioeconomic/environmental risk, geological risk, performance risk as well as design risk. Both of the above projects have arranged for “advance loss of profit” insurance, which covers the time-overrun risk and force majeure risk, the premium for which is included in the project cost subject to recovery in the form of tariff that was negotiated on the cost plus a specific rate of return basis.
In the same vein, the “fixed price” contracts (or EPC contract) that also guarantees the generation of rated capacity, includes a component of RISK FEE to cover for eventualities like cost overrun, socioeconomic/environmental mitigation cost, geological risk, failure of the plant to generate at the rated capacity and design failure (the civil/prime contractor having been reposed with the responsibility for engineering design also). It is clearly evident that these projects have been well covered from these risk by having them eventually pass through to the NEA.

Legislative Change Risk
Most importantly, as the rates of various taxes are fixed, new taxes are imposed and/or changes are made in the tax structure each year by the Parliament by promulgating Finance Act for each fiscal year and such changes in the legislation also pose serious risk to developers as such moves could dilute their return. Consequently NEA was made to accept the risk emanating from “change in legislation” in the case of these projects. NEA has taken the risk associated with the change in law by agreeing to make necessary adjustments to the negotiated tariff in order to ensure that the impact of changes in legislation on the developer is zero, in case of change in law of such nature.

Hydrological Risk
The “take-or-pay” nature of the PPA guarantees the fact that the energy produced by these plants depending on the availability of water, irrespective of whether the season is dry or wet shall be turned into cash. However, if there is no water to generate energy due to the change in the level of precipitation, climatic reason or change in the hydrology of the catchment area then these projects are on their own. Thus, the hydrological risk is the only risk the developers of these projects have taken on. This risk emanates from the fact that seasonal rainfall patterns affect the amount of water available to a hydropower plant and generation may fall below contract levels in any season, thus threatening the revenue stream of such projects. Obviously a dry year will be an unmitigated disaster for a hydropower plant.

On the Anvil
In the wake of the first two private sector ventures another PPA was signed for another run-of-the-river type of hydropower project based on Indrawati river in the same lines and at same tariff rate range. Even after more than a year of execution of the PPA this projects has not achieved financial closure. At one time Lyse Kraft from Norway was reportedly going to be a major equity holder in this project.

High Dam (Storage) Projects
Presently Enron Renewable Energy Corporation from USA and Snowy Mountains Engineering Corporation from Australia have applied for the survey licenses of Karnali-Chisapani (10,800 MW) and West Seti (720 MW) Projects respectively. Both of these are high dam (storage) projects and, therefore, these generate not only peak-in energy (which is considered a better product) but also regulated flow of water.

Downstream Benefits
Regulated flow of water has high premium in terms of downstream benefits. Flood control, irrigation, drinking water and navigation are the main benefits from these projects that accrue to the downstream riparian population/area. In the case of both Karnali and West Seti Projects the downstream riparian population happens to be in India and therefore, India stands to reap tremendous benefit from the construction of these projects. However, no mechanism exists to evaluate the benefits accruing in the downstream areas from these projects, neither in Nepal nor in India. Thereafter, it will also be necessary to fix a price for these benefits which the downstream riparian country will have to agree to recompense Nepal for such benefits.

What needs to be borne in mind is that the product that becomes available from these high dam project is not only the electricity, which can be generated even without water. However, there is no alternative to water both for drinking and irrigation purposes. Construction of such water storage high dams make the precious water available in the dry season and downstream riparian country can reap substantial gain in terms of increased agricultural productivity in the dry season. Similarly, nations are known to go a long way (even war is being predicted over water in future) to make drinking water available to its citizenry during the dry season and a storage project will result in huge amount of savings in making such arrangement. Further, there will be tremendous amount of savings due to flood control, in the absence of which downstream areas are suffering from huge losses due to flood in the first place and then they also have to spend a great deal to mitigate the ravages of flood.

Hence, implementations of high dam-storage projects call for the development of a mechanism to evaluate downstream benefit in the first place and then reaching an understanding with such beneficiary for equitable sharing by Nepal in such benefits.

Socioeconomic and Environmental Impact
Moreover, questions like whether benefits from the exploitation of hydropower potential of a specific site will percolate to the inhabitants (to be displaced or otherwise) of the area and whether socioeconomic and environmental impacts of such development will be properly mitigated and at whose cost are rearing its head. These are very sensitive questions. In the first place the royalty fixed at the moment are for the small scale projects generating electricity for domestic consumption (the rates were deliberately kept low so that the electricity tariff to the consumer could be kept low). Secondly, if the developer is to expect HMGN to take care of the mitigation aspect then present level of royalty is doubly low. Besides, present administrative structure does not allow for direct monetary benefit from such project to percolate to the project area.

Inference
In the backdrop of the above, especially the risk management/allocation part, certain people have shown the tendency to jump to the conclusion that privatization is bad. Involvement of private sector in hydropower development should not be given a bad name merely because of the various risks were apportioned in certain way in the projects under implementation currently. This needs to be turned into an opportunity to learn from the lessons inherent in present experience in the implementation of new hydropower plants. Besides the track record of public sector so far has proven that timely and judicious exploitation of this resource at reasonable cost (economic as well as social) is not possible through public sector.

In sum, one model for further development of this sector can aim at construction of mega projects to achieve national prosperity through export of hydropower and getting recompense for downstream benefits. For this purpose the current enactment, suited for small projects designed for domestic consumption, needs to be tailored for the mega projects in order to ensure that Nepal gets its due including the downstream benefit. Another model is to exploit it with an eye on taking full advantages from forward and backward linkages of such development and also ensuring that capital formation takes place for and due to these projects in Nepal, thus spurring investment activities. This requires enhancement of demand for energy beyond normal growth by commencing various economic activities (agriculture, industry, transport, tourism, health, education, etc.) and setting up of industries producing hardware and software for the construction of such plants thereby reducing import content of this sector on the one hand. On the other hand maximum amount of fund will have to be locally mobilized and invested in this sector such that the return therefrom will engender savings which will get reinvested and so on and so forth. All of these put together will not only generate more employment but the economy itself will get an overall boost.Paper presented in Small-Hydro Industry Conference in Hangzhou, China in April 1999